How Mutual Funds Are Deploying Cash in Volatile Equity Markets

November 6, 2023 Mutual Fund

The Indian equity markets have been rather volatile in the last couple of months.

A variety of factors have been behind the increased volatility:

• Ongoing geopolitical tensions (Israel-Gaza war, Russia-Ukraine war, tensions between India and China, India and Pakistan, China and the United States, China and Taiwan, and North Korea-South Korea, among others)
• Chances of economic fragmentation and possible chain disruptions (which may lead to higher headline inflation)
• Forecast by the National Oceanic and Atmospheric Administration’s climate prediction centre of strong or super El Nino weather conditions next year, which could affect water availability, food production and prices
• Central banks indicating policy interest rates may stay high
• The upswing in 10-year bond yields in the U.S. and India (due to elevated inflation, energy prices, higher policy interest rates, and higher government borrowing)
• Tighter financial conditions in the U.S., U.K., the EU, and China
• Projections of a potential recession in 2024
• And Foreign Portfolio Investors (FPIs) pulling out money in recent months

In general, the uncertainty around the world has spiked, and central banks, too, are cognisant of the downside risks.

Graphs: The World Uncertainty Index (WUI) and India VIX Graph

WUI as of September 30, 2023, while the VIX data is of November 2, 2023)
(Source: https://worlduncertaintyindex.com, NSE, data collated by PersonalFN Research) 

Although the volatility has been down since the peak of the COVID-19 pandemic, and equity mutual funds in India are witnessing inflows across various sub-categories despite the global uncertainty, fund managers have now turned cautious while deploying cash.

A fact is, even though the Indian equity market (the S&P BSE Sensex) has corrected nearly 6% since the lifetime high, Indian equities, by and large, are still expensive vis-a-vis their global peers. The Morgan Stanley Capital International (MSCI) India Index Price-to-Equity (P/E/) ratio is currently around 26x, while the MSCI Emerging Markets Index and MSCI World Index trail P/Es are at around 14x and 19x (as per the latest factsheets).

Even on a 12-month forward P/E, India is commanding a significant premium vis-a-vis emerging markets and the world.

The table below reveals equity fund managers are keeping some powder dry. Their cash allocation has increased since September 2022 (while most equity funds, in line with their investment mandate, usually tend to remain fully invested). Considering the valuations, the fund managers seem cautious.

The new equity mutual fund schemes, Bajaj Finserv Flexi Cap Fund and Samco ELSS Tax Saver Fund, which were launched in August 2023 and December 2022, are sitting on cash.

Table: Top 10 Mutual Funds with High Cash Holdings

Cash holdings include cash & cash equivalents.
Data as of September 2023 portfolio
NA for new schemes that were not in existence in September 2022.
(Source: ACE MF; data collated by PersonalFN Research) 

Other than the new schemes, the older schemes investing in small-caps, mid-caps, or following a flexi-cap approach are also now taking cash calls.

Likewise, the ones following a value/contra style of investing are becoming conscious of the opportunities.

Even certain large-cap funds and tax-saver funds (also known as ELSS) have maintained high cash allocations of late.

In all, the diversified equity mutual funds are holding Rs 75,241 crore worth of cash and cash equivalents.

You see, ever since Hamas’s attack on Israel on October 7, and Israel’s combat to eliminate Hamas through air, ground and sea attacks in which thousands of Palestinians in Gaza have lost lives, the equity markets have been even more nervous. So, the October 2023 portfolio data may reveal an even more cash allocation of equity mutual funds.

If other Middle East and non-Middle East nations, directly or indirectly get involved, a wider and intensifying conflict cannot be ruled out, which, in turn, would have a bearing on the markets worldwide.

Considering geopolitical tensions, looming economic uncertainty, bond yield curves, and valuations, equity fund managers are being careful while deploying cash. This is a tactical approach in portfolio construction of managing liquidity shall help them to make the most if the market corrects remarkably. Balancing cash and investments, perhaps, is warranted in the case of certain sub-categories of equity mutual funds.

That said, the risk for an equity mutual fund sitting on very high cash or liquidity is that it may lose out on the gains if the markets move up. India is a “bright spot” in the global economy with reforms being consciously rolled out. Favourable demographics, a strong consumption story, upbeat high-frequency indicators, and corporate earnings, among other factors, all indicate that India is a promising investment destination for wealth creation.

What should investors do?

In my view, investors should consider equity mutual funds understanding the distinct investment mandate, philosophy of the fund house and sound investment processes and systems to drive performance in the long run, and not just pay attention to past returns, which are in no way indicative of the future. Want to know how to choose the best mutual funds? Watch my video below:

[Read: Is It the Right Time to Invest in Mutual Funds Now]

As a strategy to sail through the current uncertain times, take the Systematic Investment Plan (SIP) route. SIPs shall mitigate the volatility with its inherent rupee-cost averaging feature, instil the necessary discipline of continuing with investments even during turbulent times, and potentially compound your wealth in the long run.

If you are already SIP-ping in some of the best mutual fund schemes out there, do not make the mistake of stopping or discontinuing your SIPs petrified by the market volatility. It could put brakes on the power of compounding.

Ensure your equity mutual fund is structured following the Core and Satellite approach.

Ideally, your ‘Core’ holdings of the equity portfolio should comprise around 65-70% of your equity mutual fund portfolio and comprise a Large-cap Fund, a Flexi-cap Fund, and a Value Fund/Contra Fund. These shall offer more stability to your portfolio.

The ‘Satellite’ holdings of the portfolio, on the other hand, can be around 30-35%, comprising a Mid-cap Fund, a Large & Mid-cap Fund, and an Aggressive Hybrid Fund. These shall help push up the returns in favourable market conditions.

By wisely structuring and timely reviewing the Core and Satellite holdings, you would be able to add stability to the portfolio and prove to be a wealth multiplier in the long run.

A thoughtful and prudent approach is the key to financial success.

Happy Investing!

This article first appeared on PersonalFN here